In this interview with Sean Hannity, Elon Musk shows his understanding of economics is not grounded in the real world. His two main points in this clip focus on inflation and interest rates. His explanation of inflation relates to one of Milton Friedman's old dictums: "Inflation is caused by too much money chasing too few goods". As I used to tell my students, this says everything and nothing. I'll address this simpleton's guide to inflation in a future post.
Here, I want to focus on his second point, that interest rates are high because of large government deficits. As Musk suggests, if we simply lower those deficits, then interest rates will come down. The problem with this view is the evidence is extremely weak, as can be seen in the figure below. The figure shows the relationship between government deficits as a percent of GDP (right side scale) and the 10-year US treasury interest rate (left side scale). According to Musk, as deficits get larger (a drop in the green line here), interest rates should rise (the blue line) because "government borrowing competes with the private sector for scarce funds". If this is the case, the lines should move in opposite directions; instead, they move (roughly) together. For example, since 2020, deficits have declined as a share of GDP but the 10-year interest rate has been increasing.
In the economics literature, this relationship is known as crowding out, which suggests government borrowing "crowds out" private sector borrowing by causing interest rates to rise when it competes for limited funds in capital markets. However, more often than not, larger deficits are associated with falling interest rates.
So, why is Musk (along with many economists) wrongheaded on this point? For one, in my view, the most important factor influencing long-term interest rates is inflation and expectations of future inflation. For example, from 2012 to 2019, the 10-year rate hovered between 2-3% because inflation hovered around 2%, and was expected to remain low. In 2020, the Covid shock caused inflation to increase, leading to an increase in the 10-year rate. The 10-year rate never went as high as the inflation rate, because investors expected the inflation shock was temporary, as it turned out to be.
If inflation and expectations are the primary factor moving long-term rates, then there is a mechanism for how cutting deficits could lower the 10-year rate, but it's due to the impact deficits have on growth and inflation. As an economy grows and incomes are rising, deficits naturally fall, as tax revenues are rising. However, if a government decides to slash and burn based on a false belief "we need to balance our budgets", then these austerity measures can cause a reduction in growth, if not a recession. This piece shows the austerity policies pushed by EU countries after the 2008 crisis "negatively affect(ed) economic performance by reducing GDP, inflation, consumption, and investment". In other words, the main way Musk's view would be right is because cutting deficits would lead to lower growth or a recession, which would then cause inflation and interest rates to a decline. Most inflations are tamed via recessions.
Relatedly, in this view, the impact government deficits have on long-term interest rates has more to do with how those deficits might impact inflation and not so much on the demand for scarce funds in the capital markets. In the next post, I will explain why government deficits (mostly) have little impact on interest rates which is related to the somewhat controversial view of Modern Monetary Theory.
https://x.com/elonmusk/st9330434
https://x.com/elonmusk/status/1892443739949330434
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